Obama and McCain Don't Understand Markets

With the craziness that’s been occurring in the U.S. economy recently, everyone is wondering the same thing: How will the next president handle this dire economic situation? Frank Holmes offers his prediction, below…

OBAMA AND MCCAIN DON’T UNDERSTAND MARKETS

I saw both John McCain and Joe Biden on CNBC last week, and I was astounded by the shallowness of their answers on how to address the current economic crisis.

Both offered the typical Capitol Hill solution to any problem – more regulations.

Each tried to disguise his answer in fuzzy language – McCain said he didn’t want “over-regulation” and Biden said he wanted “common-sense regulation”. But the bottom line is the same – neither of them has a real idea on how to deal with a financial crisis that has continued to escalate.

One of their blind spots goes right to the fundamental nature of the crisis that in the past few days has led to a fire sale of Merrill Lynch, driven Lehman Brothers into bankruptcy and has AIG teetering on the brink of collapse.

The Democratic and Republican candidates think of it as a Wall Street problem and that “Main Street” shouldn’t be asked to “bail out” these fat-cat financiers. This is a flawed way of looking at a financial hurricane that will defy Washington’s usual approach of exploiting the “haves vs. have-nots” issue. This is a killer storm that will flatten everything in its path.

A call for more regulations shows just how out of touch these guys are when it comes to the realities of capital markets.

The cure is not more regulation – in fact, the current rules are a big reason why we’re in this dire situation.

Almost a year ago, an accounting rule known as FAS 157 went into effect. This rule has been called the “fair-value rule,” but it’s not working that way. FAS 157 is forcing companies to write off tens of billions of dollars in debt-related investments.

That’s because of FAS 157’s requirement of a “mark-to-market” valuation on these investments each quarter. Mark-to-market essentially means the value of these investments if they had to be sold immediately. Current uncertainties and liquidity issues have chased away just about all of the buyers for many of these investments, so the markets are distorted. When there are no buyers, under FAS 157 the value has to be marked down, sometimes to zero. This is the case even for securities that could be sold in the future at face value once they reach maturity.

Overlaying FAS 157 with the demands of Sarbanes-Oxley creates a recipe for continuous quarterly write-downs until all value is gone. New York has lost its status as the world’s financial capital since Sarbanes-Oxley was enacted, and the harsh requirements of FAS 157 may accelerate that trend.

This is not a blind defense of the companies that have invested heavily in derivatives that Warren Buffett called “financial weapons of mass destruction” in 2002. In the next six years, these financial WMDs grew by 500 percent to more than $500 trillion. The sheer size of these derivatives has greatly increased the risks of catastrophe, and the danger is further elevated because of FAS 157 and Sarbanes-Oxley.

Source: U.S. Global Investors

Because global financial markets are woven in a complex web, turmoil in one sector is felt elsewhere. Some wounded financial companies are desperately selling healthy stocks to raise capital to stay afloat, and this heavy selling pressure is forcing down the price of these stocks. The same is being done by leveraged hedge funds that have been hurt by their investments in financial stocks – they need to raise money for shareholders who want out of their fund, so they are selling good stocks to get cash.

This talk of new regulation reminds me of one good rule that got away. The SEC eliminated the “uptick rule” for short-selling stocks last year, and this has facilitated a rise in illegal “naked shorting” that has hurt financial companies and impaired their ability to refinance.

The New York Times had an interesting op-ed article on this subject on Sept. 14 titled “Too Few Regulations? No, Just Ineffective Ones” by Tyler Cowen, an economics professor at George Mason University.

One of Cowen’s best observations was “financial regulation has produced a lot of laws and a lot of spending but poor priorities and little success in using the most important laws to head off a disaster. The pattern is reminiscent of how legislators often seem more interested in building new highways – which are highly visible projects – than in maintaining old ones.”

He also pointed out that 70,000 new pages of federal regulations in a single year is not an uncommon feat, and that the inflation-adjusted spending by the federal agencies regulating banking and finance has gone up more than 40 percent since 1990.

New rules are what Washington knows how to do best – it’s how legislators measure their worth. And while there are times when new regulations make sense, this isn’t one of those times.

Hearing the solutions offered by McCain and Biden today reduces my confidence that either the Democrats or the Republicans have the knowledge or the imagination to take on the biggest economic crisis in America since the 1930s.

Yesterday, U.S. stocks took another round of in-coming. The Dow dropped 372 points. The dollar went down too – the euro is headed back to $1.50.

Oil and gold, on the other hand, managed good progress. Investors may not know what causes the dollar to fall…or why the world’s post-’71 financial system is busting up…but they can smell trouble.

Oil rose $6.62, to $109. Gold had one of its best days ever – up $43…to $908.

We’ve recently begun to worry about our gold, dear reader. You see, many years ago, we bought gold coins. These we hid in various places. No problem. But after a while, it seemed so much simpler to buy the ETF! What the heck, we figured; we may not have the yellow metal in our hands, but it will be a cold day in Hell before the gold ETF goes bad.

Well, the temperature is dropping…

“Some of these ETFs in London are going to wind up operations…because they were backed by AIG,” said an English colleague this morning.

“People are getting frightened of even holding cash,” he went on. “My girlfriend’s parents are afraid their bank will go under. So, they’re dividing their money up…and putting 35,000 pounds in each account…which is the maximum amount guaranteed by the government, per account.”

As a contraction deepens, people lose faith. They wonder if corporate executives are hiding something; and if the stocks they own are worth less than they thought. They question whether loans will be repaid. They doubt that their insurer will have the money when they need it.

Bad debts multiply. Defaults increase. Bankruptcies soar.

Leveraged loan values have just hit a record low, reports Bloomberg.

And the New York Times reports that older Americans are “terrified.” They staked their retirements on housing and stocks. Both now are losing value. Worse still, they have fewer savings than any generation since WWII…and the meager savings they do have pay almost nothing!

As people fly to the safety of U.S Treasuries, yields fall. If you put money into a 91-day Treasury bill, for example, you’ll get less than 1% interest on your money. Try to live on that!

Those old people would be better with a stash of gold coins somewhere. Coins have no counterparties. No hidden liabilities. No explosive “investments” in the vault. They yield nothing…but nor do they lose value when people get scared. Instead, when the going gets rough, they typically go up in price.

Our guess is that we will hear a lot more about gold in the years ahead. Because the world’s paper money system…a system that depends on hope, faith, and the kindness of strangers…is going bust. Maybe not this week. Maybe not this year. But eventually. And each day that passes brings us closer.

At some point – and here we are just guessing, of course – investors are going to put two and two together. They’re going to realize that every increase in the U.S. government’s debts and financial obligations DECREASES the value of its paper – notably, the U.S. dollar…and U.S. Treasury bills, notes and bonds.

We don’t know…but it looked to us as though they were getting out their calculators last week. The feds announced their new bailout plan; and the price of the yellow metal suddenly shot up by $50. Again, yesterday, the $43 boost in the price of gold seemed to whisper in our ear: “they’re catching on…”

As the correction continues, we expect more and more frantic efforts on the part of the government to stop it. Look for the Fed to cut rates. Look for more bailouts…more junk on the Fed’s balance sheet…more guarantees…and more intervention. Both candidates for president, along with the media, and the voters themselves are all in favor of “doing something” to prevent assets from falling to what they are really worth.

“The time to fix this mess was a couple of years ago,” chimes in Dan Amoss. “Unless our political leaders understand how we got here in the first place, ‘fixing’ the system with regulation will only make things worse. Unfortunately, based on the public statements we’ve heard thus far, future regulations will likely include measures that throw savers and taxpayers under the bus. But on the bright side, such an environment would make it even easier to make money on the short side of the stock market. We’ll know more after this fall’s elections add some visibility to what is now an ad hoc response to each new crisis.”

*** Mr. Market has something to say about what things are worth. The feds, however, want to serve him with a gag order.

They’ve already banned short-selling on 799 financial stocks. They’ve nationalized major industries. They’ve loaded the taxpayer with a trillion worth of Wall Street’s losses. And the Bush administration, supposedly a “conservative” government, will leave office having put in place such liberal programs that they would have embarrassed Franklin Roosevelt. What won’t they do?

Most likely, Mr. Market will have his say anyway. The Japanese tried almost all these measures during the ’90s. Still, their economy sank.

In the end, U.S. financial authorities will do the math too. How can we save the average citizen? ‘We can ease his debts via inflation,’ will come the answer. How can we ease the debts on the U.S. government? Inflation will help there too. And how about all that money we owe to foreigners…and all those dollars in the vaults of foreign banks and sovereign wealth funds; what can we do about those? At some point, the politicians and U.S. financial authorities will put two and two together for themselves:

More voters are debtors…than creditors. Foreigners don’t vote at all. It would be reckless and irresponsible to print money, of course. Foreigners would stop lending; the dollar would collapse; treasuries would be wiped out. But…at some point, the math will be clear: they will have more to gain from inflation than to lose.

Of course, investors will smell it coming. They will push up the gold price…to $1,000…to $1,500…maybe to $3,000. And then, the financial authorities will prohibit trading gold. Franklin Roosevelt already set the pace; he confiscated it.

*** Thank God for the government. It came to the rescue with a package of $700 billion…expected to swell to over a trillion once the chiselers and bamboozlers figure out how to tap into it.

Economist Ken Rogoff says the bail out operation on Wall Street has left the door open for other industries. And there they are! The automakers are already on the front steps!

Don’t worry, dear reader, everything is happening just as it should. The world’s financial system is being de-leveraged, just as it should be. The most highly leveraged – that is to say, the world’s biggest speculators – are taking the biggest hits. The rest of us are – mostly – just enjoying the show.

Meanwhile, the meddlers, busy-bodies, and world improvers are having a jolly time too. Take our favorite newspaper columnist, Thomas L. Friedman – please!

In yesterday’s International Herald Tribune, Friedman mocks Ronald Reagan’s famous laugh line: “I’m from the government and I’m here to help.”

But “if it weren’t for the government bailing out Fannie Mae, Freddie Mac and AIG, and rescuing people from Hurricane Ike and pumping tons of liquidity into the banking system, our economy would be a shambles.”

How does he know what would happen if assets were marked to market? He doesn’t explain. Instead, he blithely suggests a mind-boggling absurdity…that John McCain should announce that he is raising taxes “because the most important thing for our country today is to get the government’s balance sheet in order…” Didn’t he just praise the biggest budget-busting bail out of all time…just a few paragraphs before?

But there’s no point in arguing with Friedman; even if you could win the argument, you’d be wasting your time. The man mistakes wishes for thoughts.

*** This, by Eric Hovde, appeared in the Washington Post, explaining why Congress leapt to suicide in order to bail out Wall Street:

“The Wall Street investment banking firms, their executives, their families and their political action committees contribute more to U.S. Senate and House campaigns than any other industry in America. By sprinkling some of its massive gains into the pockets of our elected officials, Wall Street bought itself protection from any tough government enforcement.

“This is no doubt the same reason why so many members of Congress were consistently blocking attempts to reform and downsize Fannie Mae and Freddie Mac, which are essentially giant, undercapitalized hedge funds. These two entities have been huge money machines for Democrats in both the House and the Senate, many of whom recently had the gall to ask why these companies hadn’t been reformed in the past. Nor should several Republican congressmen and Senators who likewise contributed to watering down legislation aimed at reforming these institutions be let off the hook.”